It is common practice for companies to provide a portion of their employees' compensation in deferred form, thus making it available to them only after a certain period of restriction. The most popular underlying instrument that is used to defer employee compensation, which is specific to the awarding company, is the awarding company's own shares. Under such arrangements, the value of the award upon full vesting and release of all restriction, henceforth referred to as the payout date, is a function of the investment performance of the company's shares during the deferral period.
Many overlaying instrument designs that refer to the underlying company's shares exist, such as phantom shares, stock options, stock appreciation rights, and variations thereof. Additionally, many features can be incorporated into a deferred compensation plan, such as conditioning the vesting of the award upon future performance of substantial services by the employee, or upon the employee meeting pre-specified performance targets. Further variations yet exist such as in the form of payment.
Other underlying instruments that are specific to the awarding company exist, such as the awarding company's own bonds, or identified pools of assets and liabilities. With these underlying instruments as well, the value of the award upon vesting and release of all restriction is a function of the investment performance of the chosen company-specific instrument.
An authoritative depiction of the state of the art in executive compensation design is described in the following document: Equity Alternatives: Restricted Stock, Performance Awards, Phantom Stock, SARs, and More, 13th Edition, ed. S. Rodrick (Oakland, Calif.: National Center for Employee Ownership, 2015), Introduction and Chapter 1.
The main objective of having the employee's deferred compensation be tied to the investment performance of the awarding company's securities is to increase the alignment of incentives between the employee and the awarding company's stakeholders, i.e., its shareholders, bondholders or others.
The main drawback of such security-based deferred compensation incentive plans is that the award often constitutes a significant portion of the employee's total wealth and constitutes an imposed concentration risk in the security issued by the plan sponsor (sponsor security), and in the industry the sponsor company is active in. The concentration risk in the sponsor security is compounded by its correlation to the employee's wage income, that is, by the fact that both the plan participant's current wage income and the value of her deferred compensation are driven to a large extent by the performance of the company that employs her, which in turn is driven to a large extent by the performance of the industry the company is active in.
The concentration in the sponsor security makes a given award be less valuable to an employee than an award of equal value that the employee can freely invest during the deferral period in a diversified portfolio of assets that is optimally chosen to suit her investment needs and risk tolerance. Conversely, the value the employee assigns to the sponsor securities is lower, due to the concentration and correlation risks, than the price the securities would fetch in the securities market if sold to well-diversified investors. The cost of the award that is expensed by the company equals the latter fair market value of the sponsor securities, and is higher than the former value the employee subjectively assigns to it. This difference between the cost and value of the deferred award constitutes an economic dead-weight cost that is borne by both the employee and the company. Meulbroek, L. (2005), Company Stock in Pension Plans: How Costly Is It? Journal of Law and Economics, 48(2), 443-474, estimates this economic dead-weight cost associated with restricted company shares at 42% of their value lost over a 10 year period.